Bonds the beating heart of the European revolution

Althea Spinozzi
Senior Fixed Income Strategist, Saxo Bank Group

Summary:  A new German government and the issuance of communitarian liability bonds should translate to higher bund yields.

The bond space will be the beating heart of the European revolution. Harmonisation of funding costs across the euro area and a common fiscal budget will be critical contributors to a much better monetary union. The change will be accelerated by a new German government and the issuance of communitarian liability bonds under the NextGenerationEU fund (NGEU).

The revolution was set in motion already last year with member states’ agreement over the NGEU fund. Within this program, the bloc is issuing common liability bonds funded by taxes raised across the broad European region at a much larger scale than it has ever done before. As the name suggests, the fund’s investment horizon is long-term, with borrowing operations estimated to end by 2026 and the deadline to pay interest and notional back set at the end of 2058. The program will contribute to a better monetary union levelling out financing conditions across the euro area. 

The German election will accelerate the profound change that the NGEU fund will cause. According to the latest polls, it looks very likely that the Green party will be part, if not the leading party, of the next German government. The Green party’s campaign centres on the need for bigger fiscal spending and better European integration. These policies translate directly to higher Bund yields and spread compression across the whole euro area. 

Both the NGEU fund and the German election are signalling that we will see more green investments in the future. That’s why a new paradigm in the European sovereign space will come with more significant issuance of joint liability green bonds.

A better and greener European Monetary Union

The European Commission is planning to issue 30% of NGEU as green bonds. However, that share can only increase in the future. 

Demand for Environmental, Social, and Corporate Governance (ESG) instruments is already exceeding supply. It will continue to rise in popularity as ESG regulations flourish worldwide and investors' awareness of these issues increases. On one side, the solid outperformance of green bonds versus traditional instruments encourages investors to increase ESG holdings. On the other, the long-term horizon of such investments appeals to policymakers because it contributes to sustainable and inclusive growth.

Debtors look with interest at opportunities to issue green bonds as they can reduce their cost of capital. Indeed, the premium these bonds are paying, also known as “greenium”, is currently between -2 to -6 basis points; a negative greenium reflects the scarcity of these instruments. 

In Europe, roughly 1% of total sovereigns outstanding are green bonds. According to Bloomberg data, almost 60% of European green sovereign bonds outstanding have been issued by France and Germany. At the same time, some countries, such as Spain, have not tapped the green market yet. The data show that much more work needs to be done for governments to satisfy green bonds demand which is constantly growing.

Expect more of the same until the German election

Until the German election, we can expect European sovereigns to continue to behave as they did since the beginning of the year. They will remain sensitive to rising US Treasury yields and tapering talks on both sides of the Atlantic

Tapering talks are a more significant concern in the United States than in Europe. However, they will weigh on US Treasuries, provoking a rise in yields in the euro area, too, as the correlation between Bund and US Treasuries continues to be positive. 

Meanwhile, we expect the ECB to keep its dovish stance until autumn as demand for European sovereigns remains weak despite continuous support. The latest 15-year Bund issuance turned into a technical failure. The German finance agency allocated only €1.7 billion out of the targeted €2.5 billion. Putting money at work in near-zero yielding Bunds is dangerous amid an inflationary environment. Also putting investors off is the fact that EUR-hedged 10-year US Treasuries with a 3-month forward offer higher yield than most of the European sovereigns.

Within this context, it's unviable for the ECB to pull support as it could lead to severe hiccups within countries' regular debt refinancing operations. Therefore, the central bank will most likely wait for the German election before tweaking monetary policy.

It's helpful to look at crucial technical levels to put into context the 10-year Bund yields' trend. Ten-year yields have recently fallen from their two-year highs in May. If they continue to fall amid dovish monetary policy messages, they could find support around -0.40%.

Yet, the long-term trend for Bund yields is to continue to rise together with the strengthening economic outlook and inflationary pressures. Therefore, although the ECB will continue to maintain its dovish stance, it is unlikely that yields will remain negative in the long term. 

Bund yields will turn positive by year-end

European bond yields can only go higher amid the German election, Europe’s increasingly robust economic outlook and stimulus coming from the EU recovery fund

While a new German government will most likely step away from austerity, the NGEU fund will eliminate some of the imbalances between countries. Stimulus coming from this fund will equalise risk among sovereigns and provoke spreads to compress versus the Bunds.

The improving macroeconomic outlook will also play a crucial part in pushing yields higher as the economy recovers and inflationary pressures will push the ECB to consider a "light taper" by the end of the year or the beginning of the next. 

How high can bond yields go? 

We are looking at two possible scenarios by the end of the year:

(1) Bund yields stabilising around 0.20%

That will be the case if the reflation trade doesn’t resurface from now until the German elections. In this scenario, yields will trade rangebound on both sides of the Atlantic. However, a government including the Green party will push Bund yields into positive territory anyway, finding resistance around 0.20%.

(2) Bund yields stabilising around 0.6%

That may be the case if we see tapering talks accelerating in the United States during summer, provoking US Treasury yields higher. Thus, we may see Bund yields turning positive before the German election. A government including the Green party will move yields higher, making it likely for 10-year Bund yields to break above their resistance at 0.20%. Therefore, they would enter a fast area where they would find resistance at 0.60% next.

A new paradigm within the European sovereign space: Italian BTPS will benefit from spread compression the most

Positive Bund yields will be a welcome change in the European sovereign space as they have not been positive since May 2019. However, positive bund yields imply that other European sovereign yields will need to move higher, too.

To better understand how the European sovereign market will shape up it's useful to focus our attention on Italy, whose government bonds are offering the highest yields in the euro area at the time of writing. 

Since the beginning of the year, the BTP-Bund spread has been trading within 90 and 126 basis points. As Mario Draghi became Prime Minister the spread tightened to the lowest level since 2015. However, as the economy reopened it widened above 100bps. 

In the short term, the spread could widen due to divergence in economic recovery and bearish sentiment amid increased volatility in the bond market. However, in the long term we expect it to tighten substantially and to stabilise around 75bps.

We anticipate spread compression to be substantially greater within BTPS than peers due to a stable political environment led by Draghi and disbursements under the NGEU fund, of which Italy will be the biggest beneficiary. The perceived improvement in risk will be met by higher investors' demand, which will find scope to sell Bunds in favour of higher-yielding sovereigns. 

Although spread compression will be bullish for BTPS, it will occur as Bund yields will be rising. It means that in the most bearish of the scenarios, we will see 10-year Bund yields rising to 0.6% and Italian BTPS 10-year stabilising around 1.4%. Bund yields will firm up around 0.20% and BTPS yields around 1% in the most bullish scenario.

In conclusion, Italian debt will also suffer losses amid a rise in Bund yields. Still, it will be more resilient compared to that of other countries.

FRENCH, SPANISH AND PORTUGUESE SOVEREIGNS WILL SUFFER THE MOST AMID RISING BUND YIELDS

We can expect spread compression to be a recurring theme within other European sovereigns to a smaller degree. What is concerning is that the ultra-low yields offered by other European government bonds expose bondholders to substantial losses. 

To give an example, at the time of writing French OATs offer roughly 0.3% in yield, and the OAT-Bund spread is around 55bps. If Bund yields rise to 0.2% and the spread between the two remains roughly the same, we can expect 10-year OAT yields to rise to 0.75%. In absolute terms, it would represent a loss of capital of 6% for French OATs. Comparatively, the loss in BTPS would be imperceptible if, amid a rise in Bund yields, the BTPS-Bund spread would tighten to 75bps.

Let’s now assume Bund yields rise to 0.6%. In that case, 10-year OATS would lose around 10%. BTPS would instead lose 5% in value.

The critical point here is that it's still necessary to create a buffer against rising interest rates. Lower-yielding sovereigns will not provide such a buffer and will add interest-rate risk to your portfolio.

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